COLLEGE SAVINGS 101

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529 E-ditorials

Determining a student's eligibility for federal financial aid is a confusing area, and nowhere are the rules more obtuse and illogical than in the area of 529 plans. If you don't believe me, just take a look at recent columns from Jane Bryant Quinn (in Newsweek) and other commentators discussing the financial aid considerations with 529 plans.

Generally speaking, the money you put INTO your 529 plan doesn't hurt your kid's aid chances very much. But taking it OUT of a 529 plan is a different story. That can hurt. Of course, no one will force you to use your 529 plan for college if doing so kills a wonderful aid package, but then you may ultimately end up canceling your 529 account and paying taxes along with a penalty. In this 529 E-ditorial, I describe the financial aid problems, along with a somewhat unusual but possibly very effective solution.

The U.S. Department of Education (aka the Education Department) is the federal agency that administers the federal aid application process utilizing a form known as the FAFSA. The instructions say that the balance in a section 529 SAVINGS PLAN is an asset belonging to the parent or other account owner. This is the good news, because a parent's asset is ""assessed"" in the aid eligibility formula at no more than 5.6%, compared to 35% for investments owned by the student. The bad news can come after you draw on the account to pay for college expenses. The reason is that the earnings portion of that withdrawal (assuming your account has grown in value) can be assessed at 50% as student income on NEXT year's FAFSA. (The Education Department has yet to decide how to treat tax-free withdrawals going forward, but you should anticipate that they will remain on the FAFSA radar.)

The people at the Education Department take a different view of 529 PREPAID TUITION PLANS. They interpret the Higher Education Act of 1965 as requiring the treatment of the benefits as a "resource" reducing a student's financial "need" on a dollar-for-dollar basis. This can severely impact a student's eligibility for subsidized loans, work-study, and certain grants.

The states offering prepaid tuition plans are obviously not pleased with the stance taken by the Education Department, and they are lobbying for equal footing with the savings plans states. Their position is that the Education Department is misinterpreting some wording in the Higher Education Act that refers to ""tuition prepayment programs"".

A more fundamental concern, according to the states, is that the families who make the financial sacrifice now to save with a 529 plan may later end up with the short end of the financial aid stick. The system is often seen as more generous to spend-happy families who intend to pay for college with future earnings (i.e. repayment of student loans) and less accessible to spend-thrifty families who accumulate past earnings (i.e. savings). How is that fair? The states are asking certain members of Congress for their help in amending the Higher Education Act to provide that savings in a 529 plan be excluded entirely from the aid eligibility formulas.

That would be great if it happened, but the odds are not real high. I have a different proposal to help families using 529 plans. That is, simply expand the definition of ""qualified higher education expenses"" to include the repayment of student loans. Under current rules it looks like any 529 funds used to repay students loans will be treated as non-qualified withdrawals subject to tax and penalty. I think this should be changed.

My proposed change would not make any difference for the family that does not rely on financial aid. The 529 account owner can choose to take qualified withdrawals from the 529 savings account or prepaid tuition contract when the student is in college just like it is done now. But if financial aid is a concern, the family could decide to delay withdrawals or contract benefits until after graduation. The student's eligibility for aid is not compromised, except for the relatively small amount counted as a parental asset, and the account is used later to pay down the loans.

The nice thing about this change is that it would not require an amendment to the Higher Education Act, nor would it require a change of heart at the Education Department. All that is needed is a simple amendment to Code section 529 to add repayment of student loans to the list of qualified higher education expenses. Congress needs to make other "technical amendments" to the law in the wake of the 2001 EGTRRA changes, so why not add this one? The insertion of student loan repayments is made even easier by the fact that tax law already defines a "qualified education loan" under the provisions controlling the deduction for student loan
interest.

The 529 savings programs could implement this change without missing a beat. The prepaid tuition plans might have to make more extensive revisions to their operational rules. I suspect most of them would be happy to do that, considering where they stand right now in the federal financial aid picture.